Securities Credit Ratings Agencies Under Attack
The securities credit ratings process needs an overhaul. Fortunately, there is renewed interest in replacing the credit rating agencies that gave high ratings to the trillion of dollars of toxic structured products that catalyzed the market meltdown, according to an April 29, 2009 Bloomberg article by David Evans and Caroline Salas entitled “Flawed Credits Ratings Reap Profits as Regulators Fail.” Three agencies control 98% of the ratings market: Standard & Poors, Moody’s and Fitch. Ever since the Enron scandal, investors and regulators have questioned the efficacy and wisdom of our rating-based market and regulatory system.
“The rating agencies are an SEC-created cartel,” says Alex Pollock, resident fellow of the American Enterprise Institute in Washington and former president of the Federal Home Loan Bank. In their article, Evans and Salas note that debt grades are embedded in hundreds of rules, laws and private contracts that affect banking, insurance, mutual funds and pension funds. As examples, they point to ratings requirements for the portfolio holdings of money market funds, and credit grades used by state regulators to monitor the safety of $450 billion of bonds held by U.S. insurance companies. Ironically, credit ratings are even used to determine how federal bailout money is allocated.
A core problem with the ratings-based system is the fact that credit agencies are paid by the companies whose debt they analyze, which creates a conflict of interest and the potential for biased and unreliable ratings, according to Lawrence White, the Arthur E. Imperator Professor of Economics at New York University. Of the big three only Moody’s is publicly traded, and has to report its financials. They show that Moody’s derives significant revenues and profits from its ratings activities. During 2008 – the year of the economic collapse – Moody’s reported revenues of $1.76 billion and a pre-tax profit margin of 41 percent, according to the article. Over the last five years, Moody’s pre-tax profit margin has averaged 52 percent. S&P and Fitch have similar profit margins, according to SEC commissioner Casey, a Bush appointee.
How can S&P, Moody’s and Fitch command such high prices? Standard & Poors President, Deven Sharma, says it is the perception of the value of its services. “Why does anybody pay $200, or whatever, for AirJordan shoes?”, he asks Bloomberg.
SEC Commissioner Casey has a different explanation: “They’ve benefited from the monopoly status that they’ve achieved with a tremendous amount of assistance from regulators.” Mr. Pollock recalled his visits with the ratings representatives when he was head of the Federal Home Loan Bank: “They’d say, ‘Here’s what it’s going to cost. … I’d say ‘That’s outrageous.’ They’d repeat, ‘This is what it’s going to cost.’ Finally, I’d say, ‘OK.’ With no ratings, you can’t sell your debt.”
The big three rating agencies graded Lehman debt A-1 (“strong”), A-2 (“low credit risk”) and A+ (“high credit quality”) on the day it filed for bankruptcy.
Connecticut Attorney General Richard Blumenthal says that the ratings agencies could receive as much as $400 million in fees from taxpayer-funded money from federal rescue efforts. “It rewards the very incompetence of Standard & Poors, Moody’s and Fitch that helped cause our current financial crisis” and [i]t enables those specific credit rating agencies to profits from their own self-enriching malfeasance,” he stated.
The various proposals to replace the ratings agencies are controversial and have been hotly contested by the ratings agencies and others. Whatever the pros and cons of the proposals and rebuttals, one thing seems clear: the present oligopoly is conflicted and flawed and has produced results that have been disastrous to many investors.
